Is The State Preference Action Cooked?Supreme Court refuses to consider appeal re the State Preference
Action

The United States Supreme Courts seems to appreciate that preference
actions are the bane of the vendor, given the Supreme Court’s
recent decision to refuse to consider the appeal form. It seems that
with any customer filing bankruptcy (no matter the bankruptcy chapter),
vendors are targeted for payments received (or even goods that were
returned by the customer) during the 90 days prior to the bankruptcy
filing. A vendor may be surprised to find that a preference action
is not limited to the federal bankruptcy system. Rather, over 20
states have also enacted state preference statutes. The effect of
the state preference law is that if a customer does not liquidate
its assets through a bankruptcy filing, but, rather, an out-of-court
liquidation, such as an assignment for benefit of creditors (“ABC”),
the vendor may still be sued for a preference pursuant to the state’s
preference law.

However, a state preference suit may now be barred under the doctrine
of preemption and the federal bankruptcy preference. The US Supreme
Court refused to consider the Ninth Circuit Court of Appeals decision,
in Sherwood Partners, Inc. v. Lycos, Inc.,1 that
an assignee under an assignment for benefit of creditors (“ABC”)
statute does not have authority to pursue preference actions under
California law. In that Ninth Circuit decision, the court ruled that
the assignee had no such authority and ordered the preference action
be dismissed. The court’s ruling and its meaning to vendors
is considered.

A. Assignment for Benefit of Creditors

The ABC is a formal out-of-court liquidation where a fiduciary takes
title to all of the debtor’s assets and liquidates them for
the benefit of the creditors. The ABC is pursuant to state law, and
is an alternative to the federal Bankruptcy Code’s Chapter
7 liquidation. Creditors are paid the proceeds in a manner similar
to that established in the Bankruptcy Code.

The procedure for the ABC varies from state to state, with some
states maintaining tight control over the process and others providing
little regulation. Generally, the assignee is selected by the debtor.
The ABC is comparable to an out-of-court Chapter 7 liquidation. However,
an ABC does not require much financial disclosure, unlike a Chapter
7 filing, which requires schedules and statement of financial affairs
to be filed. California’s ABC law permits an assignee to sue
vendors to recovery preference payments made within 90 days of the
ABC.

1. States That Have Adopted the ABC

The following states that have adopted ABC’s are Arizona,
Arkansas, California, Colorado, Delaware, District of Columbia, Florida,
Georgia, Indiana, Iowa, Kentucky, Rhode Island, Massachusetts, Michigan,
Minnesota, Mississippi, Missouri, New Jersey, New Mexico, New York,
North Carolina, South Carolina, South Dakota, North Dakota, Ohio,
Oklahoma, Pennsylvania, Tennessee, Utah, Vermont, Virginia, Washington,
West Virginia and Wisconsin.

B. Background of Preference Laws

Fundamental to insolvency law since its creation in the sixteenth
century is paying creditors of the same class an equal percentage
on their claims. This principle disfavors payments to one creditor
at the expense of other creditors of the same class. Preference laws
are central to this, and are the method to attempt to achieve the
equality of distribution to creditors. The focus of preference laws
has shifted from the culpability of the debtor, to the culpability
of creditors, to the present day standard of strict liability; e.g.
the vendor received payment within the preference period.

Preference laws seek to deter individual creditor action by threatening
recapture of transfers made during the debtor’s backslide into
insolvency. In addition, it is believed that preference actions adhere
to the policy of maximizing the insolvent estate.

1. The Bankruptcy Preference

The Bankruptcy Code vests the debtor (or trustee, or trust, if one
is appointed) withfar-reaching powers to recapture payments to creditors
within the 90 days of the bankruptcy filing. The purpose of the preference
provision is two-fold. First, unsecured creditors are discouraged
from racing to the courthouse to dismember a debtor, thereby hastening
its slide into bankruptcy. Second, debtors are deterred from preferring
certain unsecured creditors by the requirement that any unsecured
creditor that receives a greater payment than similarly situated
unsecured creditors disgorge the payment so that like creditors receive
an equal distribution of the debtor's assets.

The elements of a preference that a debtor must establish are:

A transfer of property of the debtor;

Transfer on account of an antecedent debt;

Presumption of insolvency within 90 days of bankruptcy filing;

Within 90 days (one year if an insider) before the filing of
bankruptcy;

That enables the creditor to receive more than it would have
received in liquidation. The trustee, debtor or party assigned
the avoidance actions, has the burden of proof to establish these
elements.

Not all transfers made within the preference period are avoidable.
To protect those transactions that replace value to the bankruptcy
estate previously transferred, the Bankruptcy Code carves out seven
exceptions or defenses to the trustee's recovery powers.

2. The State Preference Law

The states’ preference statutory scheme generally operate
the same as the bankruptcy preference statute. For example, in California,
where the Sherwood Partners case state preference statute was examined,
the preference statute is comparable to the bankruptcy preference
statute. Vendors may assert defenses commonly raised in a bankruptcy
preference, such as contemporaneous exchange, ordinary course of
business and new value.

Besides California, the following have also adopted state preference
laws: Colorado, Delaware, Georgia, Indiana, Iowa, Kentucky, Maryland,
Missouri, Montana, New Hampshire, New Jersey, New York, North Carolina,
Ohio, Oklahoma, Pennsylvania, South Carolina, South Dakota, Tennessee,
Washington and Wisconsin.

C. Sherwood Partners v. Lycos:

The Out-of-Court Liquidation and State Preference Suit in Action
The state preference suit in Sherwood Partners arose from an agreement
between the debtor, Thinklink Corporation, and the vendor, Lycos,
Inc. The debtor defaulted on the agreement and, through negotiations;
the debtor paid the vendor $1 million.

1. The Assignee Sues the Vendor for a Preference under State
Law

Approximately two months after the debtor paid the vendor $1 million,
the debtor made a general assignment for the benefit of creditors
to Sherwood Partners, a consulting firm, the assignee. The assignee
shut down the debtor’s business and liquidated its assets,
and sued the vendor in state court to recover the $1 million payment
as a preferential transfer.

a. Removal of Preference Action to the Federal District
Court

The vendor removed the preference suit from state court to federal
court on diversity grounds and moved to dismiss the preference suit.
The vendor argued that the state preference statute was preempted
by the federal Bankruptcy Code’s preference statute, and, therefore,
the preference suit should be dismissed.

2. The District Court Denies Vendor’s Motion to Dismiss
and Grants Preference Judgment

The vendor filed a motion with the district court to have the preference
compliant dismissed. The district court denied the vendor’s
motion to dismiss, and eventually granted judgment in favor of the
assignee for $1 million. The vendor appealed the decision to the
Ninth Circuit Court of Appeals.

3. The Ninth Circuit Court of Appeals Reverses the District
Court and Remands the Case for Dismissal

In a split decision, the Ninth Circuit compared the preference avoidance
powers granted to an assignee under the state’s preference
statute with the avoidance powers of a trustee under the Bankruptcy
Code. The Ninth Circuit determined that the assignee appointed pursuant
to the state preference statute is given new avoidance powers by
virtue of his position and the federal Bankruptcy Code preempts the
state preference statute.

a. The Bankruptcy Code Preempts the State Avoidance Statute

Key to the Ninth Circuit’s ruling that an assignee may not
prosecute preference actions under California’s state preference
statute is whether the federal bankruptcy preference statute preempts
the state preference statute. The court ruled:

“Congress’ intent to supersede state law altogether
may be found from a ‘scheme of federal regulation . . . so
pervasive as to make reasonable the inference that Congress left
no room for the Sates to supplement it . . . There can be no doubt
that federal bankruptcy law is ‘pervasive’ and involves
a federal interest ‘so dominant’ as to ‘preclude
enforcement of state laws on the same subject . . .” 2

The court found that the state statute granted the assignee new
avoidance powers as a result of the assignee’s position.

The court further noted that:

“One of the major powers the [Bankruptcy] Code gives the
trustee is the power to avoid preferential transfers. . . [and]
may be exercised only under the supervision of the federal courts.
Federal law protects creditors—particularly out-of-state
creditors like Lycos— from the trustee’s possible conflicts
of interest and other possible sources of self-dealing. [citation
omitted].”

The court held that the assignee’s prosecution of preference
actions under state law was inconsistent with the federal bankruptcy
code and was therefore preempted.

b. Assignee Appointed by Debtor a Problem

An ABC permits the debtor’s officers to select the assignee,
unlike a bankruptcy trustee in a Chapter 7 liquidation, where a trustee
is selected from a panel of trustees by the Office of the United
States Trustee, which is an adjunct of the Justice Department. In
Sherwood Partners, the Ninth Circuit court was concerned that an
assignee was not subject to U.S. Trustee or court oversight. The
Ninth Circuit found that absent this oversight, creditors were not
assured that an assignee may act in the best interests of creditors.

c. No Double Recovery Under Sate Preference Law and Federal
Law

The Ninth Circuit also was concerned that an assignee could recover
preferences under state law, distribute the proceeds, yet still face
a bankruptcy proceeding. In this setting, a bankruptcy trustee could
not also pursue preference claims against the same creditors.

4. The US Supreme Court Refuses to Consider Assignee’s
Appeal From Ninth Circuit

The US Supreme Court refused to grant certiorari to consider the
Ninth Circuit’s ruling. The consequence of the Supreme Court’s
ruling is that a vendor may now contend that the Ninth Circuit’s
decision is now binding on federal courts within the Ninth Circuit.
The vendor may also contend that federal courts outside of Ninth
Circuit should be persuaded by the court’s decision.

D. Goodbye to State Preference Actions?

1. Constitutionality of State Preference Actions

The Ninth Circuit found that an assignee may not pursue a preference
action in a state court liquidation as the federal bankruptcy code
preempted the state court preference statute.

a. Removal to Federal District Court?

As preference actions in ABC’s are generally commenced in
state courts, a vendor seeking to invoke the Sherwood decision may
need to consider removing the preference action to the federal district
court. A vendor may have a case removed to federal court on the grounds
of federalquestion jurisdiction. On the other hand, a state court
may adjudicate issues of federal preemption. Accordingly, either
way, a defense under Sherwood Partners may be raised.

2. Good News for Vendors (Facing Potential Preference Claims),
But What of Preference Claims Against Insiders?

Vendors that have received meaningful payments during the preference
period should be pleased with the Sherwood Partners decision. But
what of the insiders that may have received preference payments?
If insiders received meaningful payments from the debtor during the
preference period, is the assignee under a duty to disclose to creditors
such payments?

a. Vendors may be Better Served in ABC than Chapter 7

Depending on the vendor’s view, whether they received meaningful
payments during the preference period, may shape their decision to
support the assignment, as opposed to move for an involuntary bankruptcy
petition.

b. Does Assignee Have a Fiduciary Duty to Investigate Preferential
Transfers and Disclose the Preference Analysis to Vendors?

Under an ABC, an assignee is handpicked by the debtor’s officers.
An assignee holds the preference powers and the financial information
as to which parties received payments during the preference period.
Does an assignee, who has a fiduciary duty to creditors, have a responsibility
to conduct a preference analysis? If the assignee prepares a preference
analysis and determines there are significant preferences, both to
vendors and insiders, does the assignee file bankruptcy, thereby
losing his assignment?

3. Prejudgment Remedies may Have a Greater Appeal for the
Vendor

States generally have prejudgment remedies available for creditors
where a debtor fails to pay. Those prejudgment remedies may include
attaching a debtor’s assets. Should the creditor’s attachment
occur 90 days prior to the debtor’s bankruptcy, the creditor
would like face a preference suit. If the debtor files an ABC instead
of a bankruptcy, the attachment may not be challenged as a preference.
Given this distinction between out-of-court and bankruptcy liquidations
as a result of the Sherwood Partners decision, a vendor may be inclined
to pursue a prejudgment remedy if it anticipates that the debtor
may assign its assets.

4. More Involuntary Petitions May be Filed by Vendors so
Insider Preference Claims May be Pursued

If the debtor assigns its assets under an ABC, vendors may respond
by filing an involuntary bankruptcy petition to preserve possible
bankruptcy preference claims against insiders. An eligibility requirement
to file an involuntary petition is that thepetitioner be a creditor
holding an unsecured claim aggregating $12,300. If a debtor has greater
than 12 creditors, then three petitioning creditors’ claims
must aggregate $12,300. The petitioner’s claim must not be
subject to a bona fide dispute, and the debtor must generally not
be paying its debts when due.

a. The Abstention Doctrine may be Undermined

Even if the involuntary petition is found to be properly filed,
the bankruptcy court nevertheless may exercise its discretion to
abstain from entering an order for relief and dismiss the petition.
The grounds for dismissal are that it would be in the best interests
of the creditors and debtor, or that creditors have adequate remedies
under state law, including where state court remedies would promote
a more efficient means of administering the debtor’s assets.
Given the Sherwood Partners decision, petitioning creditors facing
an assignee’s abstention motion may have a compelling argument
for a bankruptcy jurisdiction: the assignee cannot pursue preference
claims, especially if such claims exist against insiders, the parties
that selected the assignee.

5. State Must Amend Preference Statute

The state legislature will need to amend the preference statute
to address the court’s concerns.

The Lesson for the Credit Professional

Debtors, trustees, litigation trustees, and creditors’ committees
among others seem more intent than ever to pursue preference actions
in federal bankruptcy cases. Given this bent to pursue bankruptcy
preferences, a vendor may be pleased with the Sherwood Partners decision,
especially if they have received meaningful payments from a customer
during the preference period that elects to liquidate their assets
under state law. Vendors facing preference demands and suits under
state law may consider using the Sherwood Partners as an absolute
defense to the state court preference claims, and the US Supreme
Court seems to agree.